Finance

Three areas of corporate financial management:

Capital budgeting, capital structure, working capital

Sole proprietorship

Unincorporated business owned and operated by one person

Simplest form of business ownership

General partnership

Business owned and operated by two or more people who agree to manage business, share profits, losses, and liabilities

Limited partnership

Business owned by two or more partners but the partners have different roles and different levels of liability

Corporation

Legal business entity that is separate and distinct from its owners

Owners of corporation are shareholders/stockholders because they own shares of stock in the company

Who is above a CEO?

Board of directors

Who is above chief operating and financial officers?

CEO

What is the goal of financial management?

To maximize the wealth of the firm’s owners

How does financial management maximize the wealth of the firm owners?

Maximize shareholder wealth, price, and firm value

What does it mean when a stock’s trading price (market price) is equal to its ‘true’ (intrinsic) value?

Stock has reached equilibrium and is fairly valued

Stock’s market price

What investors are willing to pay for it

Stock’s intrinsic value

What the stock is truly worth based on fundamentals and expected cash flows, dividends, growth, and risk

If investors have the wrong perception about a company, what happens to the market price?

Temporarily moves away from the stock’s intrinsic value

What causes a stock to be overvalued?

When investors are too optimistic and bid the stock price above its intrinsic values

What causes a stock to become undervalued?

When investors are too pessimistic, they may push the stock price below its intrinsic value

What should financial managers avoid?

Actions that could reduce intrinsic value

Agency relationship

When one person or group (principal) hires or relies on another person, called the agent, to act on the principal’s behalf

Principal

The owner or person whose interests should be served

Agent

The person making decisions or taking actions for the principal

Agency costs

Arise because of an agency relationship, especially when the agent may not act perfectly in the principal’s best interest

In corporate finance, who is the principal?

Shareholders/owners

In corporate finance, who are the agents?

Managers/executives hired to run the company

Direct agency costs

The visible, measurable costs that arise from trying to manage or reduce agency problems between principals and agents

Indirect agency costs

Less visible opportunity costs or losses in firm value caused by agency problems

Could be caused by poor decisions, missed opportunities, or restrictions placed on managers

Shareholders ____ the firm

Own

Board of directors _____ the firm

Oversees

Managers _____ the firm everday

Run

How do agency costs affect firm value (and shareholder wealth)?

They usually decrease firm value and reduce shareholder wealth

Managers + financial staff responsibilities

Investment and financing decisions

Coordination and control

Managing risk

What is the role of financial markets in corporate

finance?

To raise money, invest money, and determine the value of the firm

Financial market

Place where individuals and organizations that need funds are brought together with those having a surplus of funds

Importance of financial markets

Financial markets facilitate the flow of capital from investors to the users of capital

Well-functioning markets promote economic growth

Economies with well-developed markets perform better than economies with poorly-functioning markets

Cash inflow

Money coming in

Example of cash inflow

Receiving sales revenue, selling stock, receiving interest

Cash outflow

Usually shown as a negative cash flow

Examples of cash outflow

Paying expenses, buying equipment, repaying debt

1st step of cash flow

A firm raises money from investors or lenders

Selling stock, borrowing money, issuing bonds - cash inflow

2nd step of cash flow

Firm spends money from investors on things it needs to operate

Ex: equipment, inventory, buildings, tech - cash outflow

3rd step of cash flow

Firm uses those assets to sell goods or services

Ex: customers pay for products, company collects revenue - cash inflow

4th step of cashflow

Once the firm generates cash, it goes to several different places

Ex: pay taxes, employees, interest to lenders - cash outflow

Dividend

Payment a company makes to its shareholders usually from the company’s assets

Primary financial markets

Where stocks and bonds are sold for the first time

Cash flows from investors to the issuing organization

What is an IPO

An initial public offering is when a company sells stock to the public for the first time

Secondary markets

Where existing securities are resold

Secondary market: dealer market

Securities are bought and sold through dealers or market makers instead of directly between buyers and sellers

Ex: NASDAQ, a market used for cars

Secondary market: auction markets

Where buyers and sellers come together and trade securities through an auction process (bids)

Ex: NYSE, market for real estate

Step 1 IPO

Obtain approval from Board of Directors

Step 2 IPO

File registration statement with SEC

Step 3 IPO

2-day waiting period

Preliminary prospectus

Place tombstone ad

File price amendment with SEC

Preliminary prospectus

Early version of a document that gives potential investors important information about a company before it sells new securities

Tombstone ad

Formal announcement that a company is offering securities, such as stocks or bonds, to investors

SEC amendment

Means a change or update related to securities regulation or SEC things

Securities Exchange Act of 1934

Authority to regulate securities exchanges

Step 4 IPO

Sell securities to the public

Stock quote book

Display of market information for a stock

Shows prices at which investors are willing to buy/sell shares

Efficient market

A market where prices are current, fair (all investors treated equally), and reflect available information quickly

Non-efficient market

A market where prices may be slow to adjust, unfair (all investors not treated equally), outdated, or not fully reflective of available information

Efficient market hypothesis (EMH)

States that stock prices already reflect available information, so it is very difficult for investors to consistently ‘beat the market’ by finding mispriced stocks

Securities in equilibrium and fairly priced

Weak-form efficiency

Lowest level of EMH

Current stock prices already reflect all past information, such as past stock prices and trading volume

Makes it impossible to predict future prices and beat the market

Semi-strong-form efficiency

A stock’s current price already reflects all publicly available information

Once public information is released, stock price adjusts quickly so investors should not be able to beat the market

Strong-form efficiency

A stock’s current price reflects all information - both public information and private/inside information

Nobody can beat the market

Empirical studies suggest the stock market is

Highly efficient in the weak form, reasonably efficient in semi-strong form, and not efficient in the strong form (insiders make abnormal and sometimes illegal profits)

Should traders try to buy as many shares as possible after an IPO starts trading?

No, a hot IPO is very high demand and the best price is usually the IPO offering price, which is set before the stock begins trading publicly

If the market is semi-strong efficient then

Public news gets built into stock prices very quickly, which usually means other investors have reacted and prices have gone up

Current assets

Assets that a company expects to use, sell, or convert into cash within one year

Fixed assets

Long-term assets a company uses to operate the business for more than one year

Tangible fixed assets

Physical, long-term assets that a business uses to operate for more than one year

Ex: land, buildings, machinery, equipment, vehicles

Intangible fixed assets

Long-term assets that a company uses for more than one year but cannot physically touch

Ex: patents, copyrights, trademarks, brand names

Patents

Legal rights that protect an invention from being copied, made, used, or sold by others without permission

Net working capital

Measures a company’s short term financial cushion

Net working capital = current assets - current liabilities

Shareholders’ equity

The owners’ claim on a corporation’s assets after all liabilities are paid

Shareholders’ equity = total assets - total liabilites

A ‘current asset’

Asset that will convert to cash within the next 12 months

What are the three most important things to keep in mind when analyzing a balance sheet

Liquidity, debt vs equity, and market value vs book value

Liquidity

Ease of conversion versus loss of value

Liquidity is good, but liquid assets are typically less profitable to hold

Debt vs equity

Debt has priority, equity is the residual claim (claim on whatever is left over after all required payments are made)

Financial leverages

How much a company uses debt compared with equity to finance its assets

Balance sheets are based on

Assets = liabilities + equity

Market value vs book value

Generally accepted accounting principles (GAAP)

Book value: accounting records

Market value: shows the worth of assets, liabilities, and equity

Generally accepted accounting principles (GAAP)

A common set of accounting principles, standards, and procedures used in the United States when preparing financial statements

Income statement

Measures performance over some period of time, usually a quarter of a year

Income = revenues - expenses

Cash flow identity

Cash flow from assets = cash flow to creditors + cash flow to stockholders

Reflects the fact that cash is either used to pay creditors or paid out to the owners of the firm

Cash flow to creditors

Cash flow to creditors = interest paid - net new borrowing

Cash flow to stockholders

Cash flow to stockholders = dividends paid - net new equity

Operating cash flow (OCF)

Cash flow that results from the firm’s day-to-day activities of producing and selling

Does not include financing costs (interest) and non-cash expenses (depreciation)

OCF = earnings before interest and taxes (EBIT) + depreciation - taxes

Three components of free cash flow

OCF, net capital spending, and change in net working capital (NWC)

Net capital spending

Money spent on fixed assets - the money received from the sale of fixed assets

Net capital spending = ending net fixed assets - beginning net fixed assets + depreciation

Change in net working capital (NWC)

The change in NWC captures the change in the firm’s investment in current assets

Increase/decrease in a company’s short-term financial cushion from one period to another

Change in NWC = NWC end of period - NWC beginning of period

What does CFA stand for?

Cash flow from assets

Present value (PV) of a future cash flow

The value today of money you will recieve/pay in the future

PV = FV/(1+r)^t

Future value (FV) of a present cash flow

What money you have today will grow to in the future if it earns interest

Compounding

Interest can also earn interest, builds on top of each other

Ordinary annuities

Series of constant/equal cash flow from which occur at the end of each period for some fixed number of periods

Annuity due

Annuity for which the cash flows occur at the beginning of each period

Perpetuities

Perpetuities are an important special case of annuities

Series of level cash flows which continue forever